In this lesson, we will go over the foundations of modern portfolio theory. We will also look at how investors can use it to create an appropriate investment mix that optimizes risk.

Modern Portfolio Theory

John gets a bit of anxiety every time he turns on the financial news and sees that oil is down while real estate is up. He's come to the conclusion that he has no idea what the next great investment is. He wants to take an approach in his investing that allows him to achieve enough of a return to meet his retirement goals without having to worry as much about dramatic swings in the market. Modern portfolio theory presents a solution that can help John achieve this goal. Let's take a look at exactly what modern portfolio theory is and how investors can put the ideas into practice.

Definition

Modern portfolio theory is a model for maximizing investment returns which allocates a percentage of the total portfolio into different assets so that each one has their own level of risk. Instead of expecting a single asset class to provide a portfolio's returns, having multiple classes spreads out the risk. The concept was developed by Harry Markowitz in an article published in a 1952 issue of the Journal of Finance.

A risk averse investor such as John can implement modern portfolio theory by purchasing stocks and bonds according to different risk classes. The underlying idea is that when an asset class is on a massive downswing the total impact on the portfolio is reduced because other asset classes are still growing or at least not losing money as fast.

An asset class is a group of similar investments that share similar characteristics and as a group may behave differently from other groups. Some years a single class might do fairly well, and other years it loses money. A more risky investment will offer a higher potential return, but the corollary is that the investment could also experience a significant drop in value. Instead of evaluating an investment solely on its own risk and reward prospects, in modern portfolio theory the investment is considered in the context of how it impacts the total portfolio return.

Example

Let's watch as John applies modern portfolio theory into his investments. He decides he wants to use four asset classes: Government bonds, US Stocks, International Stocks, and Real Estate Investment Trusts. Over the last ten years, each class has had the following hypothetical average returns:

Bonds - 3%

US Stocks - 8%

International Stocks -7%

Real Estate Investment Trusts - 8%

With his portfolio divided up into 25% chunks, we can determine how much each class contributes to the total portfolio return.

(0.25 X 0.03) + (0.25 X 0.08) + (0.25 X 0.07) + (0.25 X 0.08)

0.0075 + 0.02 + 0.0175 + 0.02

0.065 or 6.5%

The total expected portfolio return is 6.5%. With this knowledge John can modify the percentage placed in each investment if he wanted to make adjustments such as seek a higher rate of return. He could also shift more money into bonds if he would rather have a more consistent rate of return with less risk.

Let's look at one more consideration of modern portfolio theory. Let's say that this year the stock market was completely flat; the market didn't experience any growth or any loss over the year. The bonds have kept their normal return as have the real estate investments. The portfolio return for the year looks like:

(0.25 X 0.03) + (0.25 X 0.0) + (0.25 X 0.0) + (0.25 X 0.08)

0.0075 + 0 + 0 + 0.02

0.0275 or 2.65%

By including bonds and real estate in his portfolio, those assets helped lessen the blow of poor stock market performance. 2.75% isn't awesome, but it is better than nothing! The presence of multiple asset classes smooths out the outlier swings and helps John make a more consistent and predictable return each year.

Lesson Summary

Modern portfolio theory was developed by Harry Markowitz in 1952 as a way to maximize a portfolio's return based while accounting for market risk. It serves as a way for the risk averse to create a portfolio, which is less volatile and is more likely to produce a consistent return by segregating each investment into a specific asset class.

The portfolio includes investments from different asset classes such as stocks, bonds, real estate, and can even be broken up into smaller detail such as large or small companies or government-backed securities. The portfolio funds can be allocated to these classes in order to achieve the desired expected rate of return by calculating how much of the total return each allocated portion contributes to the total portfolio.

Summary:

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